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FOREIGN EXCHANGE
MARKET
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• In the mid-1980s, American businesses became
less competitive relative to their foreign
counterparts.
By
the
2000s,
though,
competitiveness increased. Why?
• Part of the answer can be found in exchange rates.
In the 1980s, the dollar was strong, and US goods
were expensive to foreign buyers.
• By the 1990s and 2000s, the dollar weakened, so
American goods became cheaper and American
businesses became more competitive.
Foreign Exchange Market
• Most countries of the world have their
own currencies: the U.S dollar., the
euro in Europe, the Brazilian real, and
the Chinese yuan, just to name a few.
• The trading of currencies and banks
deposits is what makes up the foreign
exchange market.
What are Foreign Exchange Rates?
Two kinds of exchange rate transactions
make up the foreign exchange market:
– Spot transactions involve the near-immediate
exchange of bank deposits, completed at the
spot rate.
– Forward transactions involve exchanges at
some future date, completed at the forward
rate.
Quotation
Direct quatation: A foreign exchange rate quoted as
the domestic currency per unit of the foreign
currency. In other words, it involves quoting in fixed
units of foreign currency against variable amounts of
the domestic currency.
For example, in the U.S., a direct quote for the
Canadian dollar would be US$0.85 = C$1.
Conversely, in Canada, a direct quote for U.S. dollars
would be C$1.17 = US$1.
Why Are Exchange Rates Important?
• When the currency of your country
appreciates relative to another country, your
country's goods prices  abroad and foreign
goods prices  in your country.
1. Makes domestic businesses less competitive
2. Benefits domestic consumers (you)
Why Are Exchange Rates Important?
• For example, in 1999, the euro was valued
at $1.18. On April 26, 2006, it was valued
at $1.36.
– Euro appreciated 15% (1.36-1.18) / 1.18
– Dollar depreciated 13% (0.75-0.85) / 0.85
Note: 0.75 = 1 / 1.36, and 0.85 = 1 / 1.18
We can see exchange rates in the WSJ,
money.cnn.com, x-rates.com
How is Foreign Exchange Traded?
• FX traded in over-the-counter market
1. Most trades involve buying and selling bank
deposits denominated in different currencies.
2. Trades in the foreign exchange market involve
transactions in excess of $1 million.
3. Typical consumers buy foreign currencies
from retail dealers, such as American
Express.
• FX volume exceeds $3 trillion per day.
Exchange Rates in the Long Run
• Exchange rates are determined in
markets by the interaction of supply
and demand.
• An important concept that drives the
forces of supply and demand is the
Law
of One Price.
Exchange Rates in the Long Run: Law
of One Price
• The Law of One Price states that the
price of an identical good will be the
same throughout the world, regardless
of which country produces it.
• Example: American steel costs $100
per ton, while Japanese steel costs
10,000 yen per ton.
Exchange Rates in the Long Run: Law
of One Price
If E = 50 yen/$ then pr ice are:
In U.S.
In Japan
American Steel
Japanese Steel
$100
5000 yen
$200
10,000 yen
If E = 100 yen/$ then pr ice are:
In U.S.
In Japan
American Steel
Japanese Steel
$100
10,000 yen
$100
10,000 yen
• Law of one price  E = 100 yen/$
Exchange Rates in the Long Run: Theory of
Purchasing Power Parity (PPP)
• The theory of PPP states that exchange
rates between two currencies will adjust to
reflect changes in price levels.
• PPP  Domestic price level  10%,
domestic currency  10%
– Application of law of one price to price levels
– Works in long run, not short run
Exchange Rates in the Long Run: Theory of
Purchasing Power Parity (PPP)
• Problems with PPP
1. All goods are not identical in both countries
(i.e., Toyota versus Chevy)
2. Many goods and services are not traded (e.g.,
haircuts, land, etc.)
Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run
• Basic Principle: If a factor increases
demand for domestic goods relative to
foreign goods, the exchange rate 
• The four major factors are relative price
levels, tariffs and quotas, preferences for
domestic v. foreign goods, and productivity.
Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run
• Relative price levels: a rise in relative
price levels cause a country’s currency
to depreciate.
• Tariffs and quotas: increasing trade
barriers causes a country’s currency to
appreciate.
Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run
• Preferences for domestic v. foreign goods:
increased demand for a country’s good
causes its currency to appreciate; increased
demand for imports causes the domestic
currency to depreciate.
• Productivity: if a country is more productive
relative to another, its currency appreciates.
Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run
Exchange Rates in the Short Run
• In the short run, it is key to
recognize that an exchange rate is
nothing more than the price of
domestic bank deposits in terms
of foreign bank deposits.
Exchange Rates in the Short Run: Expected
Returns on Domestic and Foreign Assets
• A simple example:
• François the Foreigner can deposit excess
Euros locally, or he can convert them to U.S.
dollars and deposit them in a U.S. bank.
The difference in expected returns depends
on two things: local interest rates and
expected future exchange rates.
Exchange Rates in the Short Run: Expected
Returns on Domestic and Foreign Assets
• John Smith the American has a similar
problem. He can deposit excess dollars
locally, or he can convert them to Euros and
deposit them in a foreign bank.
The
difference in expected returns depends on
two things: local interest rates and expected
future exchange rates.
Exchange Rates in the Short Run:
Expected Returns and Interest Parity
Re for François
$ Deposits
i
D
E


F Deposits
Relative Re
e
t 1
i
iD  iF 
Re for John
 Et 
iD
Et
F
i
e
E
 t 1  Et 
Et
D
E


iD  iF 
e
t 1
 Et 
Et
e
E
 t 1  Et 
Et
Exchange Rates in the Short Run: Expected
Returns on Domestic and Foreign Assets
• What this shows is simple. As the relative
expected return on dollar assets increases
(decreases), both François and John
respond by holding more (fewer) dollar
assets and fewer (more) foreign assets.
• This leads us to our formal title for what is
going on here: Interest Parity
Exchange Rates in the Short Run:
Expected Returns and Interest Parity
• Interest Parity Condition
– $ and F deposits perfect substitutes
e
E
D
F
t 1  Et
i i 
Et
(2)
Example: if iD = 6% (US interest rate) and iF = 3%
(foreign currency interest rate), what is the expected
appreciation of the foreign currency?
Ete1  Et
 6%  3%  3%
Et
Exchange Rates in the Short Run:
Expected Returns and Interest Parity
Several things to recognize about the
interest rate parity condition:
•Expected returns are the same in both dollars
and foreign assets
•Equilibrium condition for the foreign exchange
market
Deriving the Demand Curve
Assume iF = 5%, Eet+1 = 1 euro/$
Point
A: Et = 1.05
(1.00 – 1.05)/1.05 = -4.8%
B: Et = 1.00
(1.00 – 1.00)/1.00 = 0.0%
C: Et+1 = 0.95
(1.00 – 0.95)/0.95 = 5.2%
• The demand curve connects these points and is
downward sloping because when Et is higher,
expected appreciation of the dollar is higher.
Exchange Rates in the Short Run:
Equilibrium
Exchange rate volatility
• Exchange rate overshooting is important
because it helps explain why foreign
exchange rates are so volatile.
• Another explanation deals with changes in
the expected appreciation of exchange
rates.
As anything changes our
expectations (price levels, productivity,
inflation, etc.), exchange rates will change
immediately.
The Practicing Manger:
Profiting from FX Forecasts
• Forecasters look at factors discussed here
• FX forecasts affect financial institutions
managers' decisions
• If forecast yen appreciate, yen depreciate,
– Sell franc assets, buy euro assets
– Make more euros loans, less yen loans
– FX traders sell yen, buy euros